Saturday, 12 October 2013

ETF Comparison: Developed Country Diversified Equities

Equities of developed market countries such as Japan, Great Britain, Germany etc (about 25 in all) should be a key part of every Canadian investor's asset mix. The diversification into economies that are not entirely in sync and into industries and companies that differ from the heavy resource structure of Canada's can add stability to a portfolio. By their ability to offer such an investment in a large number of companies and countries at low cost, ETFs are an ideal vehicle. This week we will therefore review the strengths and weaknesses of the leading ETFs for this asset class. Our objective is to look for an ETF that can be a good long term holding with broad coverage of countries, industry sectors and companies.

As with our recent review of Emerging Markets ETFs, we used ETF Database to find and get data on the US-traded ETFs in the category. For Canadian-traded ETFs, we used a combination of BMO InvestorLine (reviewed in our ETF Screeners post) and ETF Insight.

Two sets of ETF choices ...
As with Emerging markets ETFs, the largest divide in the options is between traditional passive, cap-weighted index portfolios and those based on a variety of alternative strategies that have been gaining popularity - such as fundamental accounting data weighting, high dividend payout and low portfolio volatility.

1) Traditional Cap-Weighted Index ETFs
Some are traded in US dollars on US stock exchanges, others in Canada on the TSX in Canadian dollars, though they all ultimately hold equities of developed markets countries. Thus, the risk, including any currency risk, is of those countries, not the USA. As our comparison table below shows, the asset base of US ETFs dwarf those of Canadian ETFs.

  • Vanguard FTSE Developed ex North America Index ETF (NYSE symbol: VEA) and its two Canadian clones which hold VEA but are traded on the TSX under symbol: VDU in a non-hedged version introduced this past August and VEF in a currency hedged version
  • Schwab FTSE International Equity ETF (NYSE: SCHF), which includes of fair dollop of Canadian companies
  • iShares MSCI EAFE Index Fund (NYSE: EFA), the grand-daddy behemoth of developed market ETFs and its currency-hedged Canadian clone XIN
  • iShares Core MSCI EAFE ETF (NYSE: IEFA) introduced only a year ago and catching on fast due to its lower MER fee cost and wider diversification than EFA; has an unhedged Canadian clone XEF.
  • BMO MSCI EAFE Hedged to CAD Index ETF (TSX: ZDM), which is not a clone but is hedged
Comparison Tables (click to enlarge)
Assets, MER, Performance, Taxes 

Country & Sector Holdings

 2) Alternative Strategy ETFs
There is also a mix of Canadian and US-traded ETFs in this group.

  • iShares MSCI EAFE Minimum Volatility Index Fund (NYSE: EFAV) and its Canadian clone XMI. The strategy of these funds is to minimize volatility of the ETF as a whole.
  • iShares International Select Dividend ETF (NYSE: IDV) has become popular in the USA but there's no Canadian clone so far. Holdings include Canadian companies. Consistent high dividend payers are what it holds.
  • iShares International Fundamental Index Fund (TSX: CIE) whose strategy is to select and weight stocks based on sales, cash flow, dividends and book value. It is not hedged. Interestingly, for a foreign country fund sold to Canadians, it includes Canadian stocks.
  • PowerShares FTSE RAFI Developed Markets ex-US Portfolio (NYSE: PXF) uses the same stock selection strategy as CIE but the country breakdown is quite different. Also includes Canadian companies.
  • SPDR S&P International Dividend ETF (NYSE: DWX) another high dividend seeker that includes Canadian stocks.
  • Wisdom Tree DEFA Fund (NYSE: DWM) holds consistent, not necessarily high, dividend payers and excludes Canadian stocks.

Comparison Tables (click to enlarge)
Assets, MER, Performance, Taxes 

Country & Sector Holdings

Country coverage - beware which countries are included or excluded
USA out - We have avoided ETFs containing a heavy component of US equities since we assume that investors will set aside a separate ETF holding for the equities of the world's biggest economy. Besides, many of the good ETF choices are offered on US stock markets and they exclude the USA.

Canada maybe in, maybe out - For Americans and US-based ETFs, Canada is a foreign country, thus many of the US-traded developed market ETFs contain Canadian equities. Our tables below show whether and how much Canada comprises of the total in each ETF. Though it is preferable to not have any Canadian holdings in these ETFs, since we believe investors should and probably have a separate Canadian equity ETF, the problem is not fatal. Canada is usually a fairly small portion of the ETF. Thus, if the developed country ETF is 20% of the overall portfolio, a 5% weight of Canada in the developed ETF means that another 20% x 5% = 1% is held in the overall portfolio. To compensate, an investor could reduce the main Canadian equity holding by 1%.

South Korea maybe in, maybe out - Major index provider MSCI considers South Korea to be a developing country so any ETF using MSCI as its base index provider excludes this country. Meanwhile, other major index provider FTSE says South Korea is a developed markets country. We believe that the world's 15th largest economy merits representation somewhere. The simple way to ensure it is not absent in a portfolio is to choose ETFs for developed and emerging markets (which we reviewed a few weeks back) using the same index index provider. It helps that usually FTSE or MSCI appears in the name of the ETF. Last year when major ETF provider Vanguard announced a change from MSCI to FTSE as its index for these funds, we put together this guide to the geographical structure of ETFs, a number of which we review today.

Japan and Switzerland should be in - Our desire for broad coverage means that Japan, the world's third largest economy and home to many major corporations, must be represented. Similarly, Switzerland, though a small country is home to major corporations as well, including Nestle, which is the single largest holding of a number of our ETFs. However, a couple of our ETFs - IDV and DWX - have little or none of these countries represented, a serious flaw in our view.

Hedging vs Non-Hedging - perhaps beneficial in the short term but a serious return drag in the long term
As in our discussion about this question in the Emerging markets ETFs post, the results for cap-weight ETFs EFA and XIN, as seen in the dark yellow outlined cells of the uppermost table, show a bit better results (higher one-year return, higher Sharpe Ratio - return over volatility - and lower volatility) for XIN than its internal holding EFA. The falling Canadian dollar over the past year has boosted EFA's value within XIN. But over the longer term, the returns for XIN continually lag EFA's due to the costs of hedging. For hedging to be beneficial for a Canadian investor, the considerable costs of doing it would have to be less than the drag of a sustained long term rise in the Canadian dollar against the many currencies of the developed countries, primarily the euro, yen, pound sterling, swiss franc, australian dollar etc.

Returns, Yields, MERs, Price/Earnings, Volatility - no clear picture
It is hard to discern a clear winner amongst the variety of ETFs, as the mix of green (i.e. stronger or better) and orange (comparatively weaker) numbers down and across the tables illustrate. Some ETFs have outstandingly low MERs and huge asset bases that keep bid-ask spreads tight, others better returns or Sharpe ratios, or more attractive Price/Earnings and Price/Book Value valuations. Short term returns look better for some while longer term 5-year returns look better for others. What the results will be in the very long term of decades is hard to tell, especially between the traditional cap-weight ETFs and the alternative strategy ETFS.

The portfolio volatility-minimizing objective of EFAV seems not to be very well in hand as its 1-year standard deviation is as high or worse than many of the other ETFs.

Foreign Witholding Taxes - be careful which ETF goes in which account
As we explained in Pros and Cons of Cross Border Shopping for ETFs in the USA, the clone versions of ETFs are susceptible to unrecoverable US witholding taxes in registered accounts on top of similar witholding taxes levied in the home country of the under-lying equities. Foreign non-US witholding taxes are completely lost to the Canadian investor, i.e. not avoidable and not claimable on a Canadian income tax return as a credit for foreign tax paid, in all registered accounts and for all types of ETFs. In our tables above, red text shows unrecoverable double taxation (US and other foreign), "neutral" means US tax is avoidable or Canadian tax credit is available and green text indicates US tax is avoidable and other foreign tax is claimable as a credit. Green only applies when the ETF is Canadian-traded and directly holds the equities - only CIE and ZDM are green and only in a regular taxable account. The impact is this: if an ETF distributes 3% cash and loses the standard 15% witholding tax, that is a constant 3% x 15% = 0.45% yearly return reduction. That's like doubling or more the fund's MER.

Holdings - some ETFs lack diversification
EFAV / XMI, IDV and DWX have a small number of companies in their holdings along with quite a high concentration in the top ten holdings in the latter two.

VEA / VDU / VEF, EFA / XIN, IEFA / XEF, ZDM and DWM have the convenience advantage of systematically excluding Canada from their holdings.

Bottom Line
Of the 16 ETFs under consideration, it seems a process more of elimination than selecting one or two best choices. EFAV / XMI, IDV and DWX do not achieve the diversification objective and so would be off our preferred list. We prefer non-currency hedged versions of funds but other investors may disagree and for those who do want hedging, ZDM works best from a tax viewpoint. Beyond that, the choice gets to the possible longer term benefits of alternative strategies against cap-weighting (see our post on New Improved Model Portfolios). However, the remaining choices look reasonable and the important step is to acquire and maintain a portfolio allocation in developed country equities.

Disclosure: This blogger owns some PXF.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor. 

No comments: